Cover Story: Late-cycle investing playbook

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on September 16, 2019 - September 22, 2019.

It is true that the expansionary phase of the current US economic cycle has been running longer than what is typical ... But Australia has the record for the longest expansion of more than 20 years. - Dover

Even as many investors fret about the late cycle, we are not seeing some of the typical signs associated with the late cycle. - Eng

We view the current moderation as a cyclical slowdown, with the global economy having been on a positive trend since recovering from the 2008 global financial crisis. - Chang

Given concerns about the length of the cycle, we would advise investors to target sustainable yields. - Goh

It is fair to say that we only switch portfolio allocations when the economic data tells us to. And we do not accumulate our positions. - Wong

We believe a strong service sector and consumption — supported by a still robust job market — will continue to support growth, dalbeit at a more moderate level. - Sammeer

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The global economy is in its late cycle, which is characterised as a period of increased volatility and slowing growth. But some observers have pointed out that this late cycle is distinct from other such periods in the past, especially with unique geopolitical events such as the ongoing US-China trade war and uncertainties surrounding Brexit.

Under the current circumstances, investors should be mindful of these trends and manage their portfolios accordingly, say the fund managers interviewed Personal Wealth.

One reason this late cycle is different from the others is the extent of growth in economic powerhouses such as the US, according to a report Deutsche Bank Wealth Management. The world’s largest economy is now officially in its longest period of expansion, with its GDP having grown for the last 121 consecutive months as at July.

However, investors should not be worried that this long period of expansion means a recession is imminent, says Stephen H Dover, executive vice-president and head of equities at Franklin Templeton Investments in the US. “It is true that the expansionary phase of the current US economic cycle has been running longer than what is typical. It has been more than 10 years since the last trough in 2009. But Australia has the record for the longest expansion of more than 20 years,” he adds.

Investors should consider that the nature of the economy is different now, says Dover. “Historically, when the US economy was manufacturing-based, recessions happened when inventories got too big. Over the last 20 years, as the US has moved into a more service-based economy, there isn’t that same inventory dynamic. So, I do not think we can conclude that a recession is imminent just because the current expansion is longer than it has been in the past.”

For context, there are four stages of the economic cycle. The early cycle refers to a recovery period, when the economy is coming out of a downturn and central banks are easing monetary policies. The mid-cycle is the expansion period and the late cycle is when economic activity slows and interest rates peak. The end of the cycle occurs when a recession is imminent.

Typically, economic growth hits its peak during the late cycle. According to the report Deutsche Bank Wealth Management, unemployment is low and central banks are forced to raise interest rates to deal with inflation. But this time around, inflation remains low globally and some countries are still experiencing weak growth. While the expansion period has been long, it has also been weak.

Growing uncertainty due to factors such as the trade war is causing central banks to lower interest rates instead of normalising their monetary policies.

“Investors are hoping that slow economic growth will translate into an extended cycle. To rephrase Lao Tzu, ‘the flame that burns half as bright, burns twice as long’. Even as many investors fret about the late cycle, we are not seeing some of the typical signs associated with the late cycle, like overheating economies and inflationary pressure,” says Francis Eng, chief investment officer at UOB Asset Management (M) Bhd.  

According to fund managers, the US-China trade war is something that investors should pay attention to as it will continue to affect the economy. Other potentially influential events include a hard Brexit.

“The US-China trade war will have an impact on financial markets. While most have focused on the direct impact of tariffs on economic growth, less attention has been given to the second order impact, such as how the uncertainty from the trade war could dampen the future capital expenditure and investments [of companies],” says Eng.

“We are expecting the trade war to be protracted. Thus, it could affect economic growth over the medium term.”

Irene Goh, head of multi-asset investing (Asia-Pacific) at Aberdeen Standard Investments in Hong Kong, does not foresee a quick resolution to the trade dispute. The increased political uncertainty will continue to be a feature of the economic landscape, which will negatively impact trade volumes and business investments.

“All these have critical implications for monetary policies. The response from policymakers is a key reason why we are forecasting broadly flat — rather than deteriorating — global growth over the next two years, albeit at a rate well below the post-crisis average. This implies that corporate earnings are likely to grow in the low to mid-single digits,” says Goh.

Against this backdrop, experts suggest having a balanced portfolio of equities and bonds. For instance, an Asia-focused moderately aggressive investor should have the biggest exposure to equities (46%), followed fixed income (41%) and alternative strategies (12%), says Standard Chartered Bank managing director and head of wealth management Sammeer Sharma. In terms of asset classes, he suggests that the highest exposure (20%) should be to North American equities, followed stocks in Asia ex-Japan (12%) and alternatives (12%).

An Asia and global-focused conservative investor should hold 75% in fixed income, 15% in equities and 10% in cash, with no alternative strategies, says Sammeer.

Patrick Chang, chief investment officer for Malaysia and Asean equities at Principal Asset Management Bhd, says investors should build a globally diversified portfolio that focuses on income and dividend flows. He recommends that investors hold an equal amount of stocks and bonds via balanced funds. Investors can also look at real estate investment trusts (REITs), which could provide income and dividend flows.

“These comprise real estate equity that can be viewed as ‘equity with yield’ combined with bonds such as fixed-rate commercial mortgage-backed securities (CMBS). REITs will provide both the growth element and yield while CMBS will provide a steady flow of income. A REIT, especially one that is global in nature, would fulfil our recommendation.”


Opportunities in US and Europe

Equities can benefit from a low interest rate environment and slowing growth in the global economy. Even if a recession were to occur, returns could still be positive initially, says Eng.

“Historically, an inverted yield curve has been a good predictor of recessions. From the first point when the yield curve inverts, it takes over a year on average before the economy turns into a recession. [During that time,] the S&P 500 can gain more than 20% on average, with the market peaking 1½ years later, based on historical evidence,” he adds.

According to a report UBS Global Wealth Management, stocks tend to continue performing in a late cycle as long as earnings growth remains strong, although the risk-adjusted returns will moderate.

The key yield curve (the difference between the yield of the 10-year US Treasury note and that of the 2-year note) inverted last month.

Eng recommends that investors hold some cash to take advantage of the volatility in the equity markets. “The volatility will present opportunities to investors who are disciplined. For instance, the S&P 500 initially weakened when the US imposed tariffs on some of China’s imports in May or June last year, only to rebound to new highs in the subsequent months,” he points out.

Eng likes the US market for its comparatively healthy corporate earnings outlook. He also likes the more domestic-centric markets such as Asean (excluding Singapore) as the countries are expected to fare relatively better amid the US-China trade war.

Sammeer sees the rate cut cycle as being supportive of risk assets. It is a similar situation to when the US Federal Reserve made “pre-emptive” cuts in 1995 and 1998, and a recession did not occur in the next 12 months. The central bank reduced rates as an insurance against a weakening economy, even though it did not expect a recession.

“Bond yields and equities fell sharply before the cuts [in those two years]. Twelve months after the cut, however, equities and high-yield debt delivered exceptional returns, although higher-quality debt offered muted returns,” he says.

“Within equities, we prefer US stocks, given the country’s strong economic backdrop. However, emerging-market assets also tend to do well in insurance-cut scenarios.”

On the other hand, Goh’s team is tilting its global equities exposure to developed markets over emerging markets. In her view, if the trade tensions worsened, the fallout could be worse for emerging-market equities. The team has already reduced its equity exposure in the light of certain external risks.

“On the back of a strong rally in the face of weakening global growth, we reduced our equity exposure in late July to its lowest level this year. This helped us navigate the subsequent market drawdown following US President Donald Trump’s tariff escalation and the renminbi’s abrupt depreciation,” says Goh.

According to Fidelity’s Viewpoint article, “How to invest using the business cycle” at end-June, in general, stocks show somewhat better performance on some metrics in the late cycle and cash tends to outperform bonds. But it also adds that “the indefinite frequency and magnitude of relative performance warrant more neutral allocations relative to the benchmark portfolio”.

European markets tend to perform in a late cycle due to their high exposure to inflation and rate-sensitive sectors such as commodities and financials. Dover notes that European companies have been vastly under-earning their US peers. “These stocks are trading at historical valuation discounts, offering scope for both profit improvement and multiple expansion as policy conditions normalise,” he says.

According to reports Amundi Asset Management in July, European equities are expected to be outperformers in the global equity space and provide good opportunities to investors. The pessimism on the European economy is overdone, it says, despite the potential of a no-deal Brexit and new US tariffs on European goods presenting risks. The European Central Bank’s (ECB) accommodative stance and positive trends in employment and wages are expected to support the asset class.

In the asset management company’s view, there are more opportunities in cyclical stocks in the region compared with defensive ones, which are too expensive. For instance, it likes high-quality industrial counters with strong balance sheets. There is also value in selected stocks within the banking, healthcare and telecommunications sectors.

BlackRock has upgraded its view on European equities to “neutral” due to the ECB’s policy support, according to a report in July. It even expects the central bank to exceed stimulus expectations.

The fund house prefers long-term eurozone bonds over US Treasuries despite the negative yields in markets such as Germany. That is because it views that the market has been pricing in too much US easing and disinflation.

Dover’s team will continue to identify businesses with dominant brands or franchises with high-quality management teams, healthy financial returns and a track record of resilience. “In the current environment, our portfolio managers in general are avoiding high-debt companies while targeting companies with strong cash-flow generation,” he says.

The focus on companies with strong leadership is echoed Goh. “Given concerns about the length of the cycle, we would advise investors to target sustainable yields. That means prioritising firms with free cash flow yields — which are high relative to bonds — as well as strong balance sheets and experienced management teams. They will be better placed to withstand deterioration in such conditions,” she says.


Fixed income still has a role to play

Bonds are likely to be affected the “lower for longer” environment as a result of central banks’ actions. According to reports, more than US$13 trillion worth of bonds currently have negative yields.

According to the Fidelity article, bond market sectors have exhibited economic sensitivity, just like their equity counterparts. “More credit-sensitive fixed-income sectors (such as high-yield corporate bonds) have tended to do better in the early phase of the cycle while less economically sensitive areas (such as government and other investment-grade bonds) have done relatively well in slowdowns and recessions,” it says.

The article points out that, for instance, high-yield corporates have recorded strong annual gains on average during the early cycle but have been weaker in recessions, when interest rate-sensitive investment-grade bonds have exhibited solid positive returns. “Many fixed-income categories that are fairly new to the marketplace have limited history and, hence, smaller sample sizes that make historical performance analysis less useful. Nevertheless, comparing the performance of credit and interest rate-sensitive bonds across the phases illustrates that business cycle-based asset allocation within a fixed income portfolio has considerable potential to generate active returns.”

Investors need to be cautious about credit selection, Eng warns, although fixed-income securities will continue to benefit from a low interest rate environment and monetary policy easing expected in the short to medium term. “We prefer investment grade for developed markets as most government securities are in negative yield, except for US Treasuries. We like Asian high-yield bonds as these offer higher carry while the spreads are wider than their long-term mean,” he says.

Goh also finds investment-grade credit more attractive on a risk-adjusted basis than high-yield corporate bonds, especially with a downside risk to oil prices in 2020, she says. “All in all, default rates should remain low as interest rates are capped, balance sheets are manageable and cash flows are steady.

“As for riskier assets, the extension of the cycle and the low probability of a sharp rise in bond yields should be sufficient for both investment-grade and high-yield credit to eke out positive returns. Companies with weak balance sheets should be avoided in case the cycle does come to an end.”

Sammeer and his team prefer emerging-market US dollar-denominated government bonds in view of the Fed easing its monetary policy, taking a bearish view on the US dollar and progress in US-China trade talks. “We also prefer Asian US dollar-denominated bonds in our diversified bond allocation as their strong regional demand and defensive quality offer the highest risk-adjusted yield,” he says.


Other ideas for the portfolio

With the deteriorating outlook for global growth and political uncertainty, Goh expects low returns from equity markets over the next three to five years. Similarly, lower bond yields and credit spreads mean lower expected returns from bonds.

“That is why it is important to look further afield when building a portfolio. We continue to see attractions in less traditional asset classes, including emerging-market local-currency bonds, infrastructure, asset-backed securities, property, litigation finance and healthcare royalties,” she says.

Derivatives and structured products can be considered investors who are educated on such products. “For fixed-income securities, the interest rate risk can be hedged through futures or interest rate swaps while credit risk can be hedged via credit default swaps. These hedging techniques demand a good level of understanding and are more suitable for highly sophisticated investors,” says Eng.

“For a simpler option to managing portfolio risk, look no further than keeping some cash. For example, you can earn more than 2% through US dollar deposits while waiting for desired entry levels.”

Gold, a traditional safe-haven asset, can be used to hedge downside risks. Already, the weaker US dollar and drop in US real yields have increased the demand for the precious metal. “However, a bit of patience is warranted as the recent sharp rally in gold prices has driven valuations to stretched levels,” says Sammeer.

According to him, gold could see a brief correction in the short term to US$1,380 per oz levels, which is likely to be overbought, before continuing higher. Gold prices hit a six-year high last month and are expected to keep climbing, according to various analyst reports. The gold spot rate was at US$1,493.9 per oz as at Sept 11, according to Bloomberg.

Gold-based exchange-traded funds (ETFs) — such as the SPDR Gold Shares ETF and VanEck Vectors Gold Miners ETF — also saw huge inflows during that period, with total ETF gold holdings hitting their highest levels since 2013, according to a CNBC report last month.



What about Malaysia?

Malaysian equities and bonds could benefit from the low interest rate environment and its defensive nature, say fund managers. Bonds in particular are attractive for their yields and low volatility.

Francis Eng, chief investment officer at UOB Asset Management (M) Bhd, says local bonds offer attractive yields relative to those in developed markets with the potential of monetary easing.

“The risk for Malaysian bonds is if these are excluded after the FTSE index review later this year, which could potentially trigger some bond portfolio outflows. Our base case assumes that the country will continue to be included in the index,” he adds.

Kevin Chan, head of fixed income investments at Apex Investment Services Bhd, observes that the local bond market is not expected to see too much volatility going forward. Given the shift central banks to ease monetary policy to reflate the global economy, it is currently a good environment for fixed income.

“Given this backdrop, actively managed bond portfolios provide the flexibility to move across sectors and durations. This can be advantageous to investors in the later stages of the economic expansion,” he adds.

The dovish shift to Bank Negara Malaysia’s monetary policy also supports the local bond markets, says Chan. “In particular, local corporate bonds still offer attractive spreads in our view and we believe these have more legs to run despite the recent rally, although we are cautious of companies with exposure to the US-China trade tensions.”

Within fixed income, Eng prefers corporate debt for the better yield. “But I would exercise caution in credit selection given that we are in a late-cycle environment,” he warns.

The Asian Development Bank says in its Asia Bond Monitor — June 2019 report that Malaysia was one of the emerging East Asian countries whose local currency bond markets continued their expansion in the first quarter of this year despite moderating global growth and trade conflicts.

Malaysian equities have underperformed their regional peers this year. As at Sept 10, the FBM KLCI had recorded a drop of 5.6% year to date and 8.42% over a 12-month period. comparison, equities in Singapore, Thailand and Indonesia recorded positive gains during the corresponding period.

Going forward, local equities could benefit from their defensiveness amid all the uncertainties, says Eng. Some of the sectors he likes are consumer, manufacturing, technology and oil and gas.

“In a late-cycle environment, we would focus more on defensive and quality companies. We also expect stocks that offer high dividend yields to perform relatively well under the low interest rate environment,” he adds.

Sammeer Sharma, managing director and head of wealth management at Standard Chartered Bank, and Patrick Chang, chief investment officer for Malaysia and Asean equities at Principal Asset Management Bhd, are neutral on Malaysia.

Like Eng, Chang prefers corporate credits over Malaysian government securities. As for stocks, he prefers large-cap defensive names with the ability to pay dividends.

“Meanwhile, we are kicking the tyres to look for turnaround plays and new opportunities. That is because the government has started to implement some of the previously suspended major infrastructure projects,” says Chang.

Sammeer expects Malaysia’s interest rates to fall 25 basis points the end of this year, which could benefit local bonds and local bond proxy assets such as high-dividend-yield stocks and real estate investment trusts. “[But] relative to Asian equities, Malaysian stocks continue to trade at premium valuations. Coupled with lower corporate earnings expectations, this makes Malaysian equities less attractive,” he says.



Addressing recession fears

Some investors may be concerned about an imminent recession. However, the leading indicators do not point to one in the near term, according to the fund managers Personal Wealth spoke to.

A recession is defined as two consecutive quarters of economic decline.

“The leading indicators that we track — including the yield curve, leverage, financial stress indicators, credit spreads and US Federal Reserve probability models — are pointing to a late-cycle stage of the economy rather than a recession,” says Francis Eng, chief investment officer at UOB Asset Management (M) Bhd.  

Patrick Chang, chief investment officer for Malaysia and Asean equities at Principal Asset Management Bhd, agrees. “Despite the more moderate growth momentum, there are no signs that there will be a contraction in any of the major economies over the next 12 to 18 months. We view the current moderation as a cyclical slowdown, with the global economy having been on a positive trend since recovering from the 2008 global financial crisis,” he says.

That is not to say there is no risk of a recession. According to Sammeer Sharma, managing director and head of wealth management at Standard Chartered Bank, and Irene Goh, head of multi-asset investing (Asia-Pacific) at Aberdeen Standard Investments, recession risks have increased, although it is still not high.

Sammeer’s estimates show that there is only a 35% probability of a recession occurring in the next 12 months, an increase from 30%. “While the probability of a US recession over the next 12 months has gone up slightly of late due to trade uncertainty, we believe a strong service sector and consumption — supported a still robust job market — will continue to support growth, albeit at a more moderate level,” he says.

He adds that the banking group does not view the yield curve as a perfect indicator of a recession. “We continue to focus on the fundamentals such as the US manufacturing data, which is still in positive territory albeit slowing, the unemployment rate and inflation, the absence of which will give the Fed more room to exercise its easing stance.”

The interest rate cuts central banks around the world will also help ease the situation.

“While we are seeing a manufacturing and trade recession, the service and consumer sectors are holding up well. We see the Fed’s rate cuts as sufficient to prevent a recession. Triggers to monitor include signs of labour market weakness or constraints on credit availability from the banking sector and corporate bond markets,” says Goh.



A robo-advisor’s point of view

Robo-advisors pride themselves on using technology to monitor economic conditions and automatically adjust investors’ asset allocations. Their algorithms are not supposed to react to market sentiment but be guided the underlying data.

So, are robo-advisors well equipped to protect investors’ assets in anticipation of market turmoil?

“It is fair to say that we only switch portfolio allocations when the economic data tells us to. And we do not accumulate our positions,” says Wong Wai Ken, country manager at StashAway, the country’s first licensed robo-advisor.

“Effectively, [this also means] we are not caught off guard when the markets do not move in the direction or in the time frame that a fund manager expects. We do not time the market, but focus on asset allocation instead.”

StashAway’s investors in Malaysia were notified of the first re-optimisation of their portfolios late last month. The re-optimisation process is aimed at keeping investors’ risk levels constant throughout different economic and market cycles.

The robo-advisor uses macro indicators to determine the current economic regime. A re-optimisation is only triggered events such as a change in valuations or economic regime, or if the economic conditions are highly uncertain.

According to its announcement, StashAway had taken note of the increased divergence between the growth of the US economy and that of other economies and would allocate more towards growth-oriented assets in the US and invest in more protective assets in non-US markets.

For example, more funds will be allocated to European equities, emerging-market bonds and international corporate bonds. In the US, assets will be allocated towards small-cap stocks, the healthcare sector and bonds with shorter tenures.

StashAway has identified four economic regimes that determine asset allocation — good times, inflationary growth, recession and stagflation. Currently, it is maintaining its US-based assets under a disinflationary growth (good times) regime. For non-US assets, it is implementing an all-weather strategy, used when there is unclear economic data and momentum of growth and inflation cannot provide predictive guidance.

“Having back-tested and stress-tested our portfolios using data from 2002 to 2018, our balanced to high-risk portfolios had returns of 8.6% to 10.6%. This goes to show that over the long term, our portfolios are protected in times of crisis and outperform in the long term,” says Wong.

Over the past two years, StashAway has delivered actual returns of between 3.4% and 10.7% a year (as at July). “That includes the three market corrections in 2018, when markets fell between 10% and 20%. So, it is clear that we can handle the volatility,” he says.